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AfricaOctober 2 2005

SME funding inches ahead

Innovative schemes are overturning the belief that financing African small and medium-sized enterprises is unprofitable. There may even be models for commercial banks to follow. But development finance is still needed to prove the case,James Eedes reports.
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It is something of a mantra in development circles that the key to improving the lot of the poor in Africa lies in growing the small and medium-size enterprise (SME) sector, the engine of job creation and income growth. Yet, despite an abundance of entrepreneurial energy and no shortage of viable business opportunities, Africa’s SME sector remains generally under-developed.

The reason, in part, is a lack of start-up and working capital for SMEs, funds in the order of $50,000 to $1m that can launch a business and get it onto a sustainable operational footing. Typically, investors and lenders are put off by the perceived and real risks of funding SMEs, citing such factors as little or no business experience or track record, weak business plans and low levels of collateral. Not surprisingly, commercial banks have been reluctant to service this market.

Innovative schemes

Where commercial banks fear to tread, innovative fund managers are finding ways to lend to SMEs on attractive terms. South African-headquartered GroFin manages two funds, in South Africa and east Africa. It focuses on the high-risk market of start-up and early stage small businesses, and overcomes the typical constraints of insufficient expertise, lack of track record, owner’s lack of equity or collateral through the provision of ‘business development assistance’ (essentially advice and guidance).

Through proactive assistance to an SME, GroFin is able to influence the viability and success of the enterprise and, in the process, manage the risk of lending. Loans, and occasionally long-term equity capital, of between $50,000 and $1m are then made available to qualifying SMEs. GroFin managing director Jurie Willemse says that portfolio returns of 15% above base rate are achievable before costs, a rate of return that starts to look attractive even for commercial banks.

The company manages the risk by ensuring the viability of business in the first place and then creatively structuring the financing. Under the model, GroFin works with the entrepreneur to fine-tune the business plan before making a decision on whether to approve finance. A creative portfolio of finance solutions is put together to structure a deal that makes commercial sense both for the entrepreneur and the fund manager. Typically, the entrepreneur pays market rates for the loan and limits their debt with a profit-sharing scheme that is incentivised for growth. Intervention in the business can include, for instance, help to secure long-term purchase agreements from buyers.

Attractive returns

“We have demonstrated through numerous transactions that attractive rates of return can be earned from growing Africa’s small enterprise sector,” says Mr Willemse.

To launch the first fund in South Africa, with total funding of R51m ($8m), GroFin received a ‘smart subsidy’ from the Shell Foundation – essentially a grant to develop the model. For the East Africa SME Fund, GroFin has scaled up to $23m, with funding from the UK government’s development finance arm, the Commonwealth Development Corporation; the Netherlands Development Financed Company; and two African banks.

Chris West, deputy director of the Shell Foundation, explains that GroFin’s model will plug Africa’s yawning finance gap between micro credit and multi-million dollar finance. “Although there is finance available for families to set up tiny businesses to buy assets like sewing machines, this model will never reach the scale required to have a major impact on reducing poverty. The beauty of this new fund is it makes it easier for start-up and new enterprises to gain access to the larger amounts of finance needed to make a difference,” he says.

Improved livelihoods

If successful pilot programmes in South Africa and Uganda are any indication of the potential, the East Africa SME Fund, which has recently commenced lending, is expected to improve the livelihoods of thousands of Africans. In just two years, the pilot programmes have helped hundreds of enterprises and created more than 5000 sustainable livelihoods, and are on course to generate commercial rates of return for local African banks. Successful projects include a Ugandan honey producer that has used the fund for a five-fold increase in output and to win certification to export into the EU.

Colin McCormack, MD of DFCU Group, a leading Ugandan development bank investing in the East Africa SME Fund, says: “The finance initiative has the potential to be the most important breakthrough in development thinking since the advent of micro credit. It is closing the disconnection between unserved entrepreneurs and a vast network of African banks and overseas investors that have always been put off by risk.”

Bringing together finance with business skills development is crucial to limiting the risk of lending to small companies with no collateral. Mr West says: “Lending money under these conditions is similar to a marriage because the relationship is so close. To make it work, you have to be as certain as possible about the business, and work to develop the skills of the people behind the business.”

Mr Willemse acknowledges the challenges of scaling up the model. “This is a very hands-on process, requiring sophisticated skills that are not readily available in the markets where we operate. Half of what GroFin does is human resource development and then we face a retention problem. Our people end up much better qualified than banks’ risk managers, meaning they are in demand,” he says.

The other half of the equation is funding, which GroFin has secured in relatively small amounts so far from development finance institutions. Most recently, the East Africa SME Fund received $6m in funding from Kenya’s Commercial Bank of Africa, a sign of the growing attractiveness of its activities to commercial banks.

Solutions like the GroFin model are the end goal – that is, a self-sustaining, private sector-owned and managed SME financing scheme. But, as Mr Willemse concedes, GroFin might still need further smart subsidies to roll the model out into new markets.

Even then, much has to be done to convince the broader commercial banking sector that the SME market can be profitable. And banks will have to be reoriented towards effectively serving the market.

Sustainability

The Business Linkages Challenge Fund (BLCF), which is funded by the UK’s Department for International Development (DFID), differs from the GroFin model in that it hands out grants. Although the fund is not sustainable, its objective is to prove the sustainability and viability of recipient SMEs.

Jack Newnham of the Emerging Markets Group, fund managers of the BLCF, says that often circumstances and factors all point to the viability of a venture but risk concerns, albeit small, from one or other counterparty prevent the venture from taking off. The BLCF, he says, is the necessary nudge towards the “tipping point”; a grant to “buy down” the risk and ensure the venture comes to life.

The BLCF is one of the DFID’s private sector development instruments, providing companies in target developing countries in mainly Africa and the Caribbean with grants of between £50,000 and £1m. By sharing the risk associated with getting involved in new initiatives while encouraging private sector companies to invest at least 50% of the total project funds, the BLCF leverages the capacity of the private sector to engage in projects with a high development impact.

The BLCF supports private sector partnerships that both promote commercial benefits to participating business enterprises and help to reduce poverty. Companies receive funding to increase access to markets, transfer technology, improve competitiveness or address the policy and regulatory environment for business.

Despite the development-speak ring to it, the BLCF is relatively simple in concept. Linkages are commercial relationships between two or more enterprises that increase the competitiveness and viability of the underlying venture. They could include management contracts, marketing agreements, joint ventures, partnerships, large-small firm procurement and outsourcing.

Grants are given to cover costs associated with the development and implementation of the linkage – for example, fees for the transfer and use of related skills, and the costs of linkage establishment, travel and accommodation, licensing, royalties, franchising, training courses and secondments, brochures and related promotion, quality and standards improvements, relevant legal fees, certification and patenting, and so on. The grant is intended to eliminate any obstacles to the linkage being created.

Potential is a must

According to Mr Newham, there are two criteria in particular that are important, over and above the requirement to be pro-poor. First, there must be potential for commercially attractive returns, in other words ventures must be sustainable. Second, because funds are limited, bids must exhibit “leverage” potential, that is, they must be demonstrator projects that prove the viability of markets or processes, and attract other entrants into the sector.

The BLCF’s £16.6m is fully committed across 58 projects, of which 39 projects and £9.96m are in Africa.

What role does a grant scheme play in creating sustainable private sector-led financing schemes for SMEs? After all, once committed, the BLCF’s £16.6m cannot be recycled. The answer is that financing commercially viable SMEs breaks down the perception that the risks of lending to SMEs cannot be overcome. By demonstrating the potential of different ventures, new investment is attracted. The BLCF has scored a number of successes in agriculture, agro-processing, manufacturing and tourism.

Despite hopes that commercial banks would play a bigger role in Africa’s enterprise development through the funding of SMEs, it is unlikely and unrealistic to expect them to assume additional risk when they either do not need to (if they are achieving satisfactory profits on lower risk assets); they are not able to (funding limitations of shallow, undeveloped capital markets preclude sophisticated balance sheet management); or they are not in any way organised to serve this segment properly (inappropriate internal skills). The best hope is that the viability – or more crudely, the profitability – of the SME sector is first proven. To this end, the Commission for Africa’s proposed $100m Africa Enterprise Challenge Fund, which has the backing of the UK, would mark a step up in funding for initiatives such as GroFin’s East Africa SME fund and an exclusively African version of the BLCF.

As Mr Newham concedes, fund managers like the Emerging Markets Group and GroFin would have to navigate successfully through a rigorous tendering and procurement process to be appointed fund managers. Irrespective of whether either, both or different fund managers altogether were to be appointed, an additional injection of $100m into SME financing programmes would have a significant impact on proving, or at least developing and strengthening, the business case for SME financing to commercial banks.

Rhetoric and reality

UK International Development Secretary Hillary Benn’s pre-G8 announcement of his government’s backing for the Africa Enterprise Challenge Fund came just as the UK-led campaign to put Africa at the top of the development agenda was reaching a crescendo. The London terror attacks, the intractability of Iraq, rising oil prices and most recently Hurricane Katrina have all since shifted attention away from Africa, despite famine in the west African country of Niger, proving that the pro-Africa rhetoric was removed from reality on the ground.

At best, say insiders, the Africa Enterprise Challenge Fund would only begin operations at the beginning of 2007 – a frustrating delay. It is some consolation, however, that the $550m Investment Climate Facility (ICF), which was also recommended by the Commission for Africa to strengthen the attractiveness of African economies to investment, was due to be launched this month, with an announcement of the latest developments at the Africa Investment Forum in Johannesburg, South Africa.

The proposed ICF has a widely defined mandate but it will seek ‘quick wins’ in the area of investment law, regulation, infrastructure, promotion, and so on. These are measures that will enhance the appeal and viability of Africa to investors. A significant twist is that the facility will be majority managed and run by private sector interests.

Inch by inch, there is progress. With a clear focus on private sector-led commercial viability and sustainability, Africa’s prospects for using the free market to escape poverty are a little brighter.

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